Page 20 - The Impact of the 2018 Trade War on U.S. Prices and Welfare

good comes down to two terms. First, we need to know how substitutable a good is with other

goods. The elasticity of substitution matters because consumers are more likely to appreciate being

able to purchase new differentiated goods (e.g., French red wine) than highly substitutable ones

(French wheat). Thus, all things equal, tariffs that cause varieties of differentiated products to

disappear are likely to be more costly than tariffs that cause varieties of homogeneous products to

disappear. Second, the quality of a product relative to its cost also matters. While one might think

that this is a very hard number to measure, it turns out that it is quite simple in many demand

systems. The market share of a product is a sufficient statistic for a product’s quality relative to its

cost in many common demand systems because any increase in quality or reduction in price will

increase a product’s market share by an amount determined by the demand system. In other words,

products with low quality relative to their cost will have low market shares and products with high

quality relative to their cost will have high market shares. For example, the market success of a

German beer relative to Chinese beer tells us that U.S. consumers think that spending a given

amount of money on a bottle of German beer yields more utility than spending the same amount

on a Chinese beer. Consumers may still occasionally order Chinese beer because they sometimes

like trying different beers, but they think German beer is better overall in terms of quality per dollar

spent.

Operationally, this means that the entry or exit of a variety with a large market share is going

to have a much bigger impact on consumer welfare than the entry or exit of a product with a small

market share. The variety term in these price indexes captures the impact of the gains and losses

of varieties by adjusting prices upwards by more when varieties with big market shares disappear

(e.g., German beer) than when we lose varieties with low market shares (e.g., Chinese beer).

Combining these market share terms with the substitutability parameter lets us evaluate the gains

and losses due to entering and exiting products.

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